This summer a new store opened in New York City that created more buzz than retail industry insiders had witnessed in quite a while. The store does not belong to a luxury apparel brand on swanky Madison Avenue, however. It’s a 22,000-square-foot drugstore in Manhattan’s Financial District.

The store, operated by regional chain Duane Reade, which is owned by Walgreen Co., blows apart the very idea of what a drugstore is supposed to be. Located on 40 Wall Street, in a former Chase Manhattan Bank building, it features on-site hair and nail salons, an in-store health clinic, an expansive grocery, fresh food and a makeup section worthy of a department store.

There is a stock ticker running near the entrance to the store, to update Wall Street professionals on the direction of the market. There is a holographic Virtual Assistant that greets customers at the door, provides recommendations on available products and gives information about store operating hours and services.

And just so there is no mistake about the message Duane Reade is trying to send with its new store, the word “Upmarket” is displayed in big bold letters above its front doors, and repeated throughout the aisles.

To be sure, this Duane Reade is located in a part of town populated by high-flying hedge fund managers and Wall Street brokers used to six-, seven- or eight-figure bonuses, so it’s catering to very affluent consumers. And with its uber-extensive list of services, this particular store is more likely to be a marketing play designed to get Duane Reade’s name into media outlets than a prototype of a sustainable merchandising strategy portfolio-wide, according to Mike Tesler, head of Retail Concepts Management, a Norwell, Mass.-based retail consulting firm.

At the same time, it does serve the same purpose as other drugstore chains’ efforts to expand their product selections: to set Duane Reade apart from the competition.

The store at 40 Wall Street happens to be on the extreme end of the spectrum, but Duane Reade has been remodeling its stores throughout the city to forge a better connection with its customers and project what its executives call a “New York attitude.” The strategy has allowed the chain to become more geared toward specific neighborhoods instead of selling the same products using the same techniques in areas as disparate as the Upper East Side and Coney Island, according to Brendan Langan, director of retail insights with Kantar Retail, a Columbus, Ohio-based retail consulting firm.

Duane Reade’s parent Walgreen Co. has also been remodeling its namesake stores throughout the country, and recently announced plans to upgrade its location at the iconic Empire State Building in New York, taking over 10,000 square feet on the second floor. Walgreens previously operated on the ground and concourse levels, but with the new move visitors to Empire State’s Observatory deck will be able to enter the drugstore right after they finish their tours.

CVS Caremark and Rite Aid Corp. have not stayed far behind, each launching new store formats and introducing new initiatives to target multiple consumer segments. In fact, all three national drugstore operators expanded their product selections and store fleets over the past few years. They realize that with thousands of locations already operating they have little room for new store growth, but continue to face stiff competition from discounters and dollar stores.

That has meant that the best way for drugstores to establish relevance with consumers has been to create new reasons for people to make frequent trips to their stores.

“They are really trying to clarify what their value proposition is in a very crowded retail landscape,” says Langan. “What we are starting to see is a lot of momentum against it. They really look to define what their positioning it.”

To achieve this goal, drugstores are rolling out upscale concepts, urban store concepts, co-branded stores and value store formats; they are focusing on wellness initiatives and launching private label lines, as well as adding on more non-traditional products like liquor.

Ways to be different

Last August, for example, CVS Caremark launched an initiative to convert up to 300 of its units to an urban store concept, devoting more space to non-drug-related items. In some of the converted stores, the amount of space allocated to consumables has doubled. The project proved successful enough that CVS Caremark has opted to expand the rollout. After completing 200 urban store remodels last year, it plans to do another 200 by the end of 2011, according to comments made by President and CEO Larry Merlo during the company’s second quarter earnings call with analysts on Aug. 4.

Rite Aid Corp., meanwhile, announced a partnership with supermarket operator Supervalu to operate 10 co-branded stores with Supervalu chain Save-a-Lot in the Greenville, S.C. market. The stores carry Rite Aid’s health and beauty products and Save-a-Lot groceries under the Save-a-Lot Food Store/Rite Aid Pharmacy name. The partnership has delivered strong same-store sales growth and Rite Aid Corp. is in discussions with Supervalu about expanding the program.

In addition, Rite Aid Corp. converted at least eight of its stores to a “wellness model.” The stores, designed with wider aisles and lower shelves than regular Rite Aids, carry an expanded selection of organic foods and personal care products, as well as homeopathic medicines. “Research shows that with baby boomers aging and the high cost of healthcare, people are increasingly focused on staying well and living longer,” said Rite Aid Corp. President and CEO John Standley during the company’s earnings call with analysts on June 23. “This new format is all about empowering our customers in their pursuit of wellness.”

Rite Aid Corp. plans to make these remodels the prototype of its store renovation program in fiscal 2012. It will also try out a value store format, which company executives hope will help it compete in markets where price is a main advantage.

Walgreen Co., meanwhile, has come back to selling beer and wine at 3,500 of its more than 7,000 stores since last year. The chain used to carry liquor in the 1990s, but abolished the practice after it became too cumbersome to maintain.

In addition, drugstores have been putting more and more emphasis on private label products. Duane Reade recently introduced new private label lines, including DR Delish for premium foods and Apt. 5 Goes Green, an eco-friendly version of its long-standing Apt. 5 line of household products. Walgreen Co. has come out with its Nice! line of consumables. Last year, Rite Aid Corp. spun off Simplify, a value-oriented private label brand of household items and snacks. This year, CVS launched Just the Basics, which encompasses groceries, household products, personal care products and baby care items.

“People are in [drugstores] so frequently that [drugstores have] found it’s very easy for them to sell toilet paper, bottled water and paper plates,” which have not traditionally been drugstore items, says Tesler. “Anything that gets people in, they are fighting each other for it.”

Why now?

All of these changes are taking place because drugstores suddenly find themselves operating in a fiercely competitive retail environment at the same time as their industry is reaching maturity, according to Langan. Prescription medication used to be drugstores’ main traffic draw, but today it’s no longer necessary to visit a drugstore to pick up prescriptions. In fact, many insurers insist that their subscribers use mail orders instead, says Jay McIntosh, president of Consumer Foresight LLC, an Illinois-based consulting firm. Consumers also have the option of asking for home delivery or going online.

Meanwhile, discount behemoths Target Inc. and Wal-Mart Stores now operate pharmacies within their stores, taking away drugstores’ market share in both drug and convenience categories. This year, both retailers launched small format stores in order to be able to enter urban markets, threatening to take on drugstores on their most established turf.

Supermarket chains, including Kroger, Publix and Safeway, started putting pharmacies into their stores as well. And all of these retailers are very aggressive on price, offering 30-day supplies of many generic medications for only $4.

Over the past decade, drugstores also lost another traffic driver in photo development, which used to bring multiple store trips for every roll of film, notes Langan. Those trips have all but disappeared with the prevalence of digital cameras.

Nor can drugstore chains beat the competition by blanketing the country with more units. At this point, all three major drugstore operators—Walgreen Co., CVS Caremark and Rite Aid Corp.—are at or near the point of market saturation. In Walgreen’s case, for example, “With many of the best opportunities already accounted for, its newest retail outlets may never achieve the profitability of established ones,” according to Morningstar analyst Matthew Coffina.

Branching out

On-site health clinics have been one tool that drugstores have found successful in driving more customers to their stores. Since most of the clinics operate seven days a week and require no appointment, they offer more convenience than a visit to a regular doctor’s office, at least when it comes to common conditions. Customers who don’t have health insurance might also find drugstore clinics less expensive, since the typical visit costs less than $100. Plus, there is the added benefit of having customers’ medical records and prescription histories already in the pharmacies’ systems—something many large medical institutions have a spotty record with, notes McIntosh.

To that end, CVS Caremark opened 39 so-called MinuteClinics year-to-date in 2011, bringing it to a total of 598 clinics nationally. Over the next five years, the company would like to open an additional 100 MinuteClinics, according to comments made by Larry Merlo.

Walgreen Co. also operates Take Care Clinics at its stores, which focus on prevention and treatment of common illnesses. As of May, it ran 360 such clinics. And Rite Aid started opening PromptCare health care clinics at some of its stores in 2008.

Drugstores have also realized that they could get more shopper traffic and drive more front-of-store sales by stealing customers from supermarkets and convenience stores, says Tesler. Carrying food, liquor and convenience items not only helps drugstores create more reasons for customers to visit their stores. “You might not be out for a quart of milk, but you might remember you need one while you are there,” says Tesler.

Shopper traffic has been the driver behind Rite Aid’s new value format and Duane Reade’s new upscale format. Because there are so many drugstores around the country and they are so easy to get to, the various sector competitors need to set themselves apart from their peers. By making some of their stores geared toward local preferences drugstores achieve the goal of being the stores to go to within their neighborhoods, according to Craig Johnson, president of Customer Growth Partners, a New Canaan, Conn.-based retail consulting firm.

Prime assets

Drugstores’ real estate holdings represent one of their best assets in their battle with competitors from other sectors. All three major operators exercised excellent site selection strategies over the years, going after corner locations on major thoroughfares near large residential areas, according to Nick Coo, director in the Irvine, Calif. office of real estate services firm Faris Lee Investments.

As of May 2011, Walgreen Co. operated 7,715 drugstores around the country, plus 258 stores under the Duane Reade brand. The chain has been particularly good at leasing the coveted right-hand corner locations that are positioned in the path of commuting consumers’ homebound paths, says Tesler. Today, Walgreen Co. has a store within three miles of 63 percent of U.S. consumers, according to Coffina. CVS Caremark operates approximately 7,266 drugstores nationally, and Rite Aid operates 4,704 stores.

“They have huge fleets and they compete as a convenience store without the gas pump,” says Johnson. “And they’ve had a very strong niche in a lot of urban areas, where it was difficult for chains like Target and Wal-Mart to enter.”

This should help drugstore operators ward off competition from the discounters, who have had limited luck expanding in major urban markets. Because regular Walmart and Target stores measure more than 100,000 square feet, they’ve had a lot of trouble breaking into cities like New York, where retail real estate is at a premium and huge chunks of space are hard to come by. Wal-Mart Stores’ and Target Corp.’s smaller urban stores, most of which will concentrate on selling groceries and necessities, should help them overcome that problem, but they will still be light years behind Walgreen Co., CVS and Rite Aid, who already have large established customer bases in the cities.

Still, increased competition from without could result in further consolidation within the drugstore sector. The most vulnerable player right now appears to be Rite Aid Corp., which has a low credit rating and is struggling to bring down its debt level. Over the past year, the company was also forced to close 63 underperforming stores and rumors persist that the chain may be sold.

“When you look at Rite Aid, you see a fundamental shift in terms of their philosophy. What you are looking at is a retailer that has employed very homogenous store bases becoming multi-format and more focused on localizing and clustering,” says Langan. “Over the next 12 to 18 months, this is their window to show what they can do.”